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On July 25, 2017, the SEC issued a Report of Investigation under Section 21(a) of the Securities Exchange Act of 1934 (Exchange Act) describing an investigation of “The DAO,” a virtual organization, and its use of distributed ledger or blockchain technology to facilitate the offer and sale of DAO Tokens to raise capital.[1]

An initial coin offering (ICO), such as The DAO’s token sale, is a relatively new form of offering that involves the creation of a digital token or coin based on distributed ledger or blockchain technology. These coins or tokens may be offered to the public in exchange for virtual currency (most commonly Bitcoin or Ether). Though the average investor may not understand these technologies, entities and individuals are increasingly using ICOs to raise and invest capital. After they are issued, virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms.

From April 30, 2016 through May 28, 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens through an ICO, in exchange for a total of approximately 12 million Ether. The offer to purchase DAO Tokens was extended to any investor, as long as the investor paid in the required currency, Ether. At the offering’s close, The DAO raised approximately $150 million worth of Ether, designed to finance projects approved by a vote of DAO Token holders, who would then share the earnings.

The SEC’s investigation sought to determine whether The DAO Tokens and similar instruments constitute securities under the Securities Act of 1933 (Securities Act) and the Exchange Act. If an instrument is found to be a security, it becomes subject to federal securities laws which, among other things, require registration with the SEC as well as periodic reporting to the agency in the absence of an exemption from registration.

Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act broadly define a security to include investment contracts. Though not defined within these statutes, the Supreme Court in SEC v. W.J. Howey Co. set forth a three-prong test to determine whether a financial instrument is an “investment contract.”[2] The three-prong Howey test analyzes (1) whether there is an investment of money in a common enterprise; (2) whether there is a reasonable expectation of profits from the investment; and (3) whether the expected profits are to be derived from the managerial efforts of others.

In applying the Howey test, the SEC determined that an investment of the digital currency Ether in exchange for a share of The DAO’s future earnings qualified the tokens as securities. It is notable, however, that the SEC did not declare this finding to mean that all tokens are securities, nor did it decide to pursue civil penalties or take disciplinary action against The DAO.

It appears as though the SEC used this investigation as an opportunity to provide guidance for evolving technologies and to stress that “the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless of whether those securities are purchased using U.S. dollars or virtual currencies, and regardless of whether they are distributed in certificated form or through distributed ledger technology.” Depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities. If they are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws.

In its report, the SEC also clarified that The DAO offering would not fall under the JOBS Act’s crowdfunding exemption because, among other things, “it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.” In addition to the investigative report, the SEC’s Office of Investor Education and Advocacy issued an investor bulletin to provide information to investors about ICOs. The bulletin reminds investors of the potential risks of participating in ICOs and several red flags of investment fraud.

If your entity is considering raising capital, through an ICO or otherwise, it is important to first speak with a securities attorney to ensure your offering complies with state and federal securities laws.

[1] Section 21(a) of the Exchange Act authorizes the SEC to investigate violations of the federal securities laws and, in its discretion, to “publish information concerning any such violations.”